Doug Duncan, chief economist for Fannie Mae, confirmed what I have been saying about prepay speeds. He stated that 70% of mortgagor applicants will not be able to “make the cut” given the industry’s tighter underwriting standards. I think this gives further credence to my January 6th blog (“12/31 Prepay Speeds are Overstated”) stating that the MSR industry should be using 11/30 prepay speeds for their year-end valuations. This should be a much more accurate reflection of what is going to happen.

I am troubled by 12/31 prepay speed projections. I just don’t believe them. While I do think they represent what a potential bidder would use to value an MSR acquisition, I would argue strongly that this is a temporary, distressed market, driven by fear and panic. In my estimation it will not last and 11/30 projections will be seen as more reasonable.

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On December 16th the FOMC reduced rates significantly. This resulted in a very large increase in prepay models projections. Chaos theorists have shown that models tend to work best in fairly narrow bands of reality. Outside of these bands, models predictive capabilities plummet. A case in point is the credit risk models used by rating agencies over the last several years. Their predictive abilities were catastrophically reduced by the large change in the global economic environment. It can very easily be argued that today’s mortgage rates (amidst other economic dynamics) are also outside of the bands of reality incorporated into these prepay models.

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These models are driven primarily by interest rate arbitrage opportunities. Because mortgage rates are approaching 5.00%, they anticipate a large number of mortgagors refinancing their mortgage. There has, in fact, been a spike in applications over the last month. The real unknown is pull-through rate, which is not adequately considered in most commercially available models. It is too early to tell what impact softening real estate markets, and tightening underwriting and documentation standards will have on the approval of these applications. Many mortgagors are approaching their loan officers still believing that their house value is what it was in 2005. This is ordinarily not the case.

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The next three months will be critical in understanding this pull-through rate and, thus, reasonable prepay speed projections. Because we are in uncharted territory, the market has assumed the worst case scenario. The Servicing Source believes that actual prepays (i.e. pull through) will be much less than that indicated by 12/31 prepay models and that the 11/30 prepay projections are more reasonable.

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Accounting literature allows that “fair value” is not the same as “distressed value”. I would argue strongly that 12/31 prepay speeds represent the latter and 11/30 prepay speeds more accurately reflect value.